Sovereign Debt, Reputation, and Credit Terms

NBER Working Paper No. 3424Issued in August 1990NBER Program(s): ITIIFM

I develop a model in which sovereign debtors repay debt in order to maintain a reputation for repayment. Repayment gives creditors reason to think that the debtor will suffer adverse consequences if it defaults, so they continue to lend. I compare a situation in which competitive lenders earn a zero profit on each loan with one in which they can make long-term commitments to individual borrowers, so that the zero-profit condition applies only in the long run. In many circumstances a borrower benefits, ex ante, if lenders commit to denying credit to a borrower in default even if at that point a subsequent loan is profitable. Furthermore, a "debt overhang," while possibly altering credit terms, does not cause profitable investment opportunities to go unexploited.